Monday, August 9, 2010

Is Your Startup A Cash or Equity Business?

There are, broadly speaking, 2 types of ways to build value in a business.
(a) An "equity" based business in which the stock value will grow significantly with time
(b) A "cash" based business, in which the company will generate a lot of cash on an annual basis, but the value of the stock will remain a low multiple of earnings.

Figuring out what sort of business you want to start, (or, in hindsight, have started) impacts everything from whether you should raise money to how to compensate your employees. A fundamental misunderstanding of what sort of business you have can lead to mistakes that derail the success and potential of the company.

Equity Businesses

Raise money: Raise from angels, VCs, hedge funds, you name it. Usually you need to invest a large amount of cash (usually from external investors and operations) over the lifetime of growing the business before you really create value and make money at scale. Hopefully your company will do well and your returns are sufficient to meet venture economics.

Employee compensation: Biased towards options and low cash. You don't want to pay employees a lot as you will have to keep raising money. Raising money will dilute the equity, which is where the long term value is.

Time horizon: The average M&A exit is 6.5 years and most companies take many years to go public. Value is usually created reasonably later in the companies life.

Example companies: Google, Facebook, Twitter

Other key characteristics: These companies typically have a period where they are not throwing off a lot of cash up front, but rather are reinvesting in growing and scaling the business. Equity based businesses may lose money for the first few years before emerging as a cash machine as their unique position in the industry takes hold (think Facebook). Similarly, these businesses often have strong network effects, strong barriers to entry, customer lock in, or other characteristics that make the equity value of the business high.

Cash Businesses

Raise money: Focus on angels / individuals or self fund/bootstrap. The returns you are likely to expect won't justify venture returns but you will be able to pay out cash as a dividend.

Employee compensation: Pay out more of your profits in cash as equity is only a minor consideration - as the equity value of these companies is low (i.e. you can't sell the company for much to other buyers).

Time horizon: Often these sorts of business start generating cash quickly (on the order of a few months to a year - think Hot or Not).

Example companies: Most of the smaller social gaming companies. Most GroupOn clones.

Other key characteristics: Often these businesses have lower barriers to entry, fewer network effects, or are focused on small or niche markets with few buyers for the business.

Note, as companies mature they may transition from equity to cash businesses or vice versa. E.g. Microsoft is no longer a great bet in terms of stock upside, but they do pay a healthy dividend and generate a good ROE. Similarly, GroupOn is both a cash business (think of all the small GroupOn clones which are instantly profitable) which builds equity value over time via branding, distribution, and scale.